1. Field of the Invention
The invention relates generally to financial services, and in particular, to the calculation of risk management and trading cost information for traditional and non-traditional markets.
2. Background Art
The risk management tools and techniques available to market makers and other traders in financial markets have been either rudimentary or based on well-established models. Walrasian call markets, where traders enter bids and offers at a specified time to permit all market participants to see and react to the bids and offers of their peers, rarely attract market makers. A market clearing price is obtained quickly in these markets and any inter-temporal market making activity is limited. In the more complex continuous auction market model, buyers and sellers enter bids and offers during a trading session for interaction with other bids and offers. The primary role of the market maker in a continuous auction market is to trade with both buyers and sellers, providing liquidity when it is needed and, generally, dampening price fluctuations by intermediating transactions over time.
A Walrasian call market is used where trading volumes are light and there is little or no need for continuous liquidity and little or no formal market making. The continuous auction market is the standard for most global securities and futures markets. Market maker risk management in these markets is well developed. At the most elementary level, a market maker's risk management consists of position control. By limiting the size of a position, the market maker will limit its exposure to price risk by minimizing the size of its net long or net short position. At the next level of risk management complexity, the market maker will hedge a long or short position by taking a risk-offsetting position in a return-correlated instrument in a related market. As markets have become increasingly sophisticated, as trading hours have expanded, as the geographic locations of trading venues for similar or identical items have become more dispersed, and as electronic markets have reduced order pendency times and direct human involvement in market making, the risk management function has become more complex, more automated and, usually, more effective. Effective risk management now includes management of exposures to price fluctuations in particular markets, limitations on exposures to related risk categories and protection from a variety of risks that are not directly linked to the items in the market maker's trading inventory.
On balance, the availability of a growing number of traded items with differently correlated risks, longer trading hours, and more dispersed markets has stimulated the development of sophisticated computer-based aggregate risk management techniques. Sophisticated systems facilitate better hedging of individual risks and cross-hedging of similar risks in a variety of markets world wide. With specific reference to the products and markets considered herein, the hedging practices of market makers in exchange-traded funds and in most types of securities these funds hold have increasingly focused on reducing hedging costs by using low market impact portfolio risk management instruments rather than specific security-by-security risk offsets.
Non-traditional market structures that depart in material ways from the Walrasian and simple instrument continuous auction market models are also changing the nature of market maker risk management. The nature of the risks market makers encounter in new products and nontraditional markets and the tools market makers use to manage their risks have changed in important ways. The introduction of new order types, new financial instruments and new transaction processing features that permit electronic exchange trading at or relative to a price to be determined in the future require new kinds of information and new risk management tools. There is, therefore, a need for risk management tools and information for market makers and other market participants trading actively managed and non-transparent index exchange-traded funds in traditional continuous auction markets and in markets where the actual transaction price is contingent on a net asset value to be determined at a specified time under specified conditions.